June 23, 2016 | by Olivia Gonzalez and Eileen Norcross Print

Global crude oil prices finally started to creep back up in June in response to both political disruptions to oil production and growing demand. This trend — a reversal of what we’ve seen since 2014 — may be a good sign for producers, but it also introduces volatility into the market. This not only poses a threat to producers as they set expectations about profits in the next year, but has implications for the finances of state governments here in the United States.

Some states levy a large proportion of their taxes on oil production and other natural resources in order to fund government activities. If oil prices continue to rise, these industries will do well. As policymakers should know, though, this is far from guaranteed. Relying on oil and gas production as a revenue source is a risky bet. It also contravenes recommendations by economists to look for sustainable revenue sources and to keep tax bases broad.

This is only one part of the story unveiled in the 2016 edition of “Ranking the States by Fiscal Condition,” which I helped produce with Senior Research Fellow Eileen Norcross for the Mercatus Center at George Mason University. Curious about the condition of state finances, we looked at the financials of all 50 states and ranked them according to their fiscal health. Drawing from data on taxes, spending, and other key financial information, we found that states have many reasons to be wary, both on the revenue and the spending sides of the ledger.

States that rank poorly tend to have large debt obligations and growing pension liabilities. The bottom five states — Kentucky, Illinois, New Jersey, Massachusetts, and Connecticut — all exhibit serious signs of financial stress, making them extremely susceptible to fiscal crises if a recession were to take place. Their growing unfunded liabilities also pose a huge risk to taxpayers in both the short and long term.

Even the top five states — Alaska, Nebraska, Wyoming, North Dakota, and South Dakota — are in positions that can worsen if they aren’t careful. They may have significantly more cash on hand and relatively low short-term debt obligations than other states, but the makeup of their funding sources has the potential to cause their fiscal health to deteriorate.

In particular, states whose economies and government revenues rely heavily on oil production may see their rankings worsen in years to come. This is especially true given that the most recent available data for analyzing their fiscal condition is from 2014, before oil prices dropped significantly.

In three of the top five states — Alaska, North Dakota, and Wyoming — oil, natural gas, and mining account for about 10 percent or more of their gross domestic products. State governments can’t control the makeup of their economy, but they do have power to shift away from oil as their primary revenue source.

Consider Alaska, a state with severance taxes on oil production that accounted for about 72 percent of its tax revenue in 2014. Although the state raised more than $5 billion from this tax in 2012, declining oil prices reduced this to almost nothing in 2015, resulting in a budget deficit. Thankfully, Alaska policymakers are considering structural changes to the state’s budget and tax system. Proposals have been made for the implementation of an income tax and to reduce the rebate checks sent to citizens.

The state’s proposed reforms are not perfect, but it is encouraging to see an effort to diversify their funding sources. Policymakers should not be tempted merely to increase the oil and gas severance taxes that are already in place.

What’s more, the funds that states raise from taxation of natural resource extraction are not always accessible. Alaska and Wyoming operate permanent trusts that contain these proceeds, generating large principals that cannot be accessed for general spending.

Alaska’s high expenses in relation to the state’s wealth also point to an overreliance on volatile revenue sources. The state ranks 50th in “service-level solvency,” which measures how high taxes, revenues, and spending are as a proportion of the state’s personal income.

This form of unstainable spending is not unique to the top states. States at the bottom of the ranking have questionable revenue sources, as well. Extremely narrow income tax bases present similar risks to the bottom states that oil and gas taxes do for the top states. The income taxes in New Jersey and Connecticut, which respectively rank 48th and 50th, are progressive and fall primarily on high-income citizens. Relying too heavily on them as a revenue source is unreliable — and there is very little empirical evidence that they reduce income inequality, which is often the main reason they are implemented.

It is especially concerning to see the revenues generated by a progressive income tax make up as much of 40 percent of a state’s revenue, like in New Jersey. What’s even more alarming is that less than 1 percent of taxpayers contribute about a third of those collections, making the state vulnerable to a drop in revenues if those individuals decide to leave the state.

Policymakers should take it as a warning sign if just a handful of individuals can detrimentally impact their state’s coffers. In New Jersey, only one individual is affecting the state’s ledger by leaving the state. The relocation of the wealthiest individual in New Jersey, billionaire hedge-fund manager David Tepper, is leaving policymakers concerned about the potential budget gap that could result from his move.

These states could learn a lot from Florida — the state to which Tepper relocated. Ranking sixth in our report, Florida does not have an income tax or an estate tax. Even more importantly, it does not rely as heavily on volatile revenue sources like New Jersey and Alaska do. Florida also has considerable cash on hand to cover liabilities, is generating a surplus, and has relatively low levels of pension debt.

Whether politicians are taxing natural resources or wealthy citizens, the lesson is the same: Targeting a narrow portion of the tax base is unsustainable and places unnecessary stress on budgets if things don’t go as planned. It’s easy for state officials to get comfortable when the government is flush with cash during good economic times, but that never lasts forever.

The crises in Alaska and New Jersey demonstrate that poor fiscal practices are evident in states across the fiscal health and political spectrum. Top-performing states are just as susceptible to budget stress as other states, and structural weaknesses in their tax systems don’t make them any more prepared.

Olivia Gonzalez portrait
Olivia Gonzalez is a research assistant for the State and Local Policy Project for the Mercatus Center at George Mason University. Her research focuses on state budgets, taxes, and economic development. Learn More about Olivia Gonzalez >
Eileen Norcross portrait
Eileen Norcross is a senior research fellow at the Mercatus Center at George Mason University. As director for the Mercatus Center’s State and Local Policy Project, she focuses on questions of public finance and how economic institutions support or hamper economic resiliency and civil society. She specializes in fiscal federalism and institutions, state and local governments and finance, pensions, public administration, and economic development. Learn More about Eileen Norcross >